As briefly mentioned in chapter 10, the price of an option is the sum of two components: intrinsic value and time value.

Intrinsic value

To recapitulate, the intrinsic value of an American option is:

The intrinsic value of a European option is the difference, if positive, between the current price of the underlying and the discounted present value of the strike price for calls and vice versa for puts.

As was seen in chapter 10, an option which has intrinsic value is said to be ‘in-the-money’ and one with no intrinsic value is either ‘at-the-money’ or ‘out-of-the-money’. In the case of traded options the premium is usually referred to as the ‘price’ of the option and hence the term pricing refers to how the premium is determined.

Time value

As regards the second component, time value, this is due to the fact that even if the price may be unattractive today, future fluctuations may make the option profitable. The time value depends on the interplay of a number of factors:

Time

It is obvious that the longer the period of time, the greater are the chances of price fluctuations and vice-versa. Thus, time value generally varies directly with amount of time left to maturity. This leads to the fact that options are wasting assets: as an option's expiration date approaches, its time value diminishes and eventually becomes nil. The only value remaining is the intrinsic worth, if any. Therefore, if an option is not sold or exercised by the expiration date, it becomes worthless. (This is important from an investor's point of view: in contrast to options, underlying assets like shares can be held indefinitely.)

Extent of the difference between current price and strike price

An option which is deeply out-of-the-money has a lower time value than an option which is only slightly out-of-the-money. A deep OTM option has a much lower probability of ever becoming profitable than one which is slightly OTM for the same maturity period.